The CBOE Stock Exchange, in a departure from the current vogue among stock exchanges, is launching in March with a specialist system. The offshoot of the Chicago Board Options Exchange recently appointed six trading houses as “designated primary market makers,” or specialists, to provide liquidity to its upcoming equities marketplace.
The move makes the firms the sole liquidity providers receiving the highest transaction fee advantages for the stocks in which they make markets. Each stock and exchange-traded fund is assigned to one DPM and several remote market makers (RMMs). The latter compete for order flow and have fee benefits over market participants.
The adoption of a specialist structure is a sharp contrast to the approaches taken by the newly invigorated regional stock exchanges and, to a large extent, NYSE Arca. These players have all opted for competing market-maker platforms for the trading of New York Stock Exchange, American Stock Exchange and Nasdaq securities. Besides the CBSX, only the New York and American stock exchanges operate specialist systems.
Eric Noll, global head of strategic relationships at Susquehanna Investment Group, points out that in recent years specialist systems have virtually disappeared. “The CBOE Stock Exchange makes the opposite side of that argument-which is that an exchange with dedicated liquidity providers will provide more liquidity than those models without it,” he says.
For DPMs, Noll adds, one advantage of a new exchange is that it offers specialist firms the ability to be that single liquidity provider. The NYSE, for example, has already allocated most names to specialists and shut that door.
In creating the role of the DPM, the CBSX took a page from its own book. The position of DPMs on the CBSX, while more limited, is similar to that of DPMs on the CBOE’s options marketplace. Both provide liquidity-and the exchange has the carrot and stick to ensure it.
DPM Carrot
In both cases, the DPM role is defined by certain benefits and obligations unavailable to other traders. The benefit on the CBSX is an unusually high rebate for providing liquidity. DPMs will get the same amount per share for providing liquidity that other market participants pay for taking it. “DPMs play an important role in attracting orders to come to us, so we’re compensating them for that through rebates,” says CBSX president David Harris.
The exchange in general has high rebates for customers posting liquidity and volume-based fees for those taking liquidity from the system.
DPMs will pay the same tiered take fees as other market participants. But their rebates for providing liquidity will be significantly higher. “We’ll rebate them what the taker pays,” Harris says. “So it’s essentially a pass-through.”
Under the CBSX’s tentative pricing program, takers may pay anywhere from 27 to 30 cents per 100 shares, based on the volume they execute on the CBSX. That amount is what the DPM will receive when it is the contra side of that order.
RMMs, a secondary class of dealer, will get more than the rebate of 25 cents per 100 shares that market participants get under the CBSX’s pricing scheme, but less than the pass-through rebate DPMs receive. RMMs will compete for flow with the DPMs and others.
The exchange plans to revise the maker/taker fees just prior to its March launch, to reflect competition in the market.
DPMs will have only fee-based incentives to make markets. They will not have participation rights that guarantee them a piece of incoming orders if they join others at the NBBO. This avoids concerns about market makers sitting at the top of the pyramid, seeing all the incoming flow and choosing what to execute against, Harris says. Options specialists are permitted to interact with up to 40 percent of an incoming order if they are at the best bid or offer.
“DPMs won’t be able to pick and choose who they interact with,” Harris adds. “By being the first to provide the best price, they get to interact with all incoming orders. Some of those customers will be paying 30 cents per 100 shares, and some less.”
Susquehanna’s Noll says that most of the liquidity provision by DPMs isn’t likely to be in highly liquid names. Those securities have sufficient flow. “It’s in markets that are not as deep and where there’s not as much two-sided interest that the CBSX will have its highest impact,” he says.
The CBSX is half-owned by the Chicago Board Options Exchange and half owned by four market-making firms-Interactive Brokers Group, LaBranche & Co., Susquehanna International Group and VDM Specialists. In addition to the market-making units of those four, CBSX’s six DPM organizations include Wolverine Trading and Equitec Specialists.
DPM Stick
To qualify for the generous rebate, DPMs will be held to strict quoting and size requirements, Harris says. All must make continuous, two-sided markets. But the CBSX will also set “liquidity provider guidelines” for every stock, based on that stock’s price, volume and trading characteristics. The guidelines will dictate the bid-ask spread and size the CBSX will disseminate for each stock. Market makers’ obligations will be driven by those guidelines. If a stock’s spread widens beyond what CBSX’s guidelines specify, DPMs and RMMs must jump in to tighten the market.
In those cases, DPMs and RMMs will have to provide two-sided and two-tiered markets. They must narrow the spread with an inside market that caters to smaller orders, and quote an “outside market that will accommodate executions for larger orders at a wider spread,” according to the exchange.
DPMs will have to meet the liquidity provider guidelines in 90 percent of the instances when CBSX’s disseminated market widens beyond the guideline’s specifications. RMMs will have to meet the guidelines for stocks they quote 50 percent of the time.
The CBSX plans to launch on March 5 with a slate of 12 to 30 stocks and ETFs. The exchange plans eventually to trade 2,800 equities, including NYSE, Nasdaq and Amex-listed securities.
Layoff Business in Crosshairs
The new CBOE Stock Exchange expects to grab 6 to 7 percent of the overall equities business-if not more-over the next three or four years, says CBSX president David Harris.
A large chunk of that is likely to come from the options layoff business, which currently goes to the New York Stock Exchange, NYSE Arca and Nasdaq.
The CBSX’s hybrid market includes a fully electronic platform with price-time priority and a floor in Chicago to cater to options traders. The exchange’s physical floor, staffed by DPM organizations, is at Post 10 of the CBOE’s fourth-floor trading room, just yards from the exchange’s equity options traders.
“We want our options guys to trade with our stock guys,” says CBOE chairman and chief executive Bill Brodsky.
CBOE options traders hedging large positions or putting on complex strategies can walk over to the DPM in a particular stock and get a firm price. To facilitate the huge options layoff business, the CBSX will also have a number of new order types, including the “sweep and cross,” which enables market participants to enter both sides of a cross and sweep better prices at away markets.
Given the cutthroat equities market, a lot is also riding on the exchange’s ECN-like maker/taker fees. “Our model, which rebates at a high level, allows firms with a lot of flow to have us in a better position on their routing table,” Harris says. Many quantitative equity shops take rebates into account when deciding how and where to place their orders. Those firms sending the CBSX a lot of volume will also pay lower take fees.
According to Harris, the exchange can offer a higher rebate than some exchanges and ECNs because the CBSX is a low-cost facility with just two fulltime employees.
-Nina Mehta
-Additional reporting by Peter Chapman
